Deferred Tax on a Business Combination and Foreign Subsidiary Translation
Pacific Group Ltd acquires 100% of KiwiCo, a New Zealand subsidiary, on 1 January 20X5 for NZ$8,000,000. At acquisition, KiwiCo's identifiable net assets have a fair value of NZ$7,200,000, including plant with a fair value NZ$1,000,000 above its tax base of NZ$600,000 (carrying amount NZ$1,600,000). The tax rate in New Zealand is 28%. Goodwill of NZ$800,000 is recognised. Pacific's functional currency is AUD; the AUD:NZD exchange rate was 1.10 at acquisition and 1.05 at 31 December 20X5. KiwiCo's profit for the year was NZ$900,000, earned evenly. The CFO proposes to recognise a deferred tax liability on the goodwill and to translate goodwill at the closing rate.
1. Calculate the deferred tax arising at acquisition and explain the treatment of the temporary difference on the plant and on goodwill.
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Plant temporary difference: The fair value adjustment creates a taxable temporary difference of $1,000,000 ($1,600,000 carrying amount − $600,000 tax base). A deferred tax liability is recognised at 28% = $280,000. This reduces the fair value of identifiable net assets to $7,200,000 − $280,000 = $6,920,000, increasing goodwill to $8,000,000 − $6,920,000 = $1,080,000.
Goodwill: No deferred tax is recognised on the initial recognition of goodwill. The initial recognition exemption applies: a temporary difference arising from the initial recognition of goodwill is not recognised because it is not a business combination (it arises from the business combination) and does not affect accounting or taxable profit at inception. The CFO's proposal to recognise a DTL on goodwill is incorrect.
Note: the exemption does not apply to the plant because the plant's temporary difference arises from a business combination and affects taxable profit through depreciation.
2. Translate KiwiCo's goodwill and profit into AUD and explain the exchange differences.
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Goodwill translation: Goodwill is a non-monetary asset of the foreign operation and is translated at the historical rate (the rate at acquisition, 1.10), not the closing rate. Goodwill in AUD = NZ$1,080,000 ÷ 1.10 = A$981,818. The CFO's proposal to use the closing rate is wrong.
Profit translation: Income and expenses are translated at the average rate for the period. Since profit was earned evenly, the average rate is the mid-point of opening (1.10) and closing (1.05) = 1.075. Profit in AUD = NZ$900,000 ÷ 1.075 = A$837,209.
Exchange differences: The difference between translating assets and liabilities at the closing rate (1.05) and equity at historical rates is recognised in other comprehensive income and accumulated in a foreign currency translation reserve. This reserve is reclassified to profit or loss only on disposal of the foreign operation. The goodwill translation difference forms part of the translation reserve.
3. Explain how the acquisition method affects the group's deferred tax disclosures.
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Pacific must disclose:
- The deferred tax liability recognised on the plant fair value adjustment ($280,000), including the fact that it increased goodwill.
- The unrecognised deferred tax relating to the goodwill (nil recognised due to the initial recognition exemption) and the reasons.
- The deferred tax expense for the year, split between temporary differences and the effect of tax rate changes.
- The translation reserve movement and the exchange rates used (closing 1.05, average 1.075, historical 1.10).
Because the plant's fair value uplift will reverse through tax depreciation over its useful life, Pacific should track the reversal and recognise deferred tax movements in profit or loss as the temporary difference unwinds. The CFO's approach would overstate liabilities and misstate goodwill, so the group should correct the draft accounts before finalising.